If you’re someone who is approaching retirement, your thoughts are probably consumed with the amount of free time that’s just around the corner. By now, hopefully, you’ve looked at your finances, created a plan, and are set to eventually enjoy the fruits of many decades of labor.
You’ve been diligent and have saved throughout the years to fund this retirement paradise. Perhaps you’re one of the lucky few who have some sort of pension with a guaranteed monthly stipend. Or, you’ve gotten lucky in the market and you’ll have plenty to live on.
For most people, however, their retirement projections rely on another source of income: Social Security.
But what you may not realize though is that income coming in from a 401(k), 403(b), or other provisional income may cause your Social Security to be taxed.
What?
Social Security Can Be Taxed?
Yep, and guess what?
Although it was originally designed to only capture this tax on the “wealthy”, the government has changed the rules. Now, more and more Americans are being taxed. At one time it only affected about 10% of us. Now, it’s closer to 50%.
What does this mean for you?
Exactly as it sounds. Less money for you to spend in your retirement.
What’s the history on Social Security taxation?
The stock market crash of the 1920s and subsequent Great Depression caused one of the worst economic crises in modern history. President Roosevelt created the Social Security Act in 1935. The goal was to add economic stability and security to aging Americans. It was designed as a social insurance program where workers made contributions to a “trust fund” to pay for benefits they would receive in the future.
At this time payouts were not taxed at all. However, all of this changed in 1984 when Social Security benefits started to be taxed.
The way it was initially designed, however, was that only a small portion of Americans would be affected. In a 1983 report, the National Commission on Social Security Reform gave an estimate that less than 10% of those receiving benefits would pay income tax on their Social Security.
Additionally, at the time, only up to 50% of your Social Security income was taxed. The income threshold at the time was $25,000 for single filers and $32,000 for married. Meaning, you would have to make more than this amount in a year before any of your Social Security was taxed.
You’re Being Taxed More Today Than Ever Before
What you must consider, though, was at that time, the average national wage in 1985 was about $16,822 per year.
This effectively eliminated most people from ever being taxed on their Social Security because taxes weren’t a concern unless you made over $25k. And, remember, if you were taxed, it was only a max of 50% of your benefits at your nominal tax bracket at the time.
Let’s look at modern times.
The median income in 2021 for those aged 65-69 was $53,951 (some estimates are northward of $60k). This was generally earned through 401(k)s, IRAs, and Pensions. Some people also continued to work in this age group, thus adding to their annual amounts.
So, people are now making more.
However, the income limits to be taxed on your Social Security benefits didn’t keep pace with wages!
They kept the income limit thresholds below inflation so more and more people are now having to pay taxes on their benefits! “Taxation of Social Security benefits is growing over time” because the income limits “are not indexed to inflation or wage growth.”
On top of this, now even more of your benefits can be taxed. In 1994, President Bill Clinton proposed taxation to be increased from 50% to 85% of your benefits.
What Are The Rates?
Single filing status
- Currently, up to 50% of your benefits will be taxed if your adjusted gross income is between $25,000 to $34,000 as an individual.
- Earn more than $34,000 and up to 85% of it will be taxed. Remember, this is a figure on your adjusted gross income, after deductions have been figured into the equation.
Married filing jointly
- If you’re married, up to 50% will be taxed if your income is $32,000 to $44,000.
- Make over that and you’re up to 85% of your benefits can be taxed.
Here is the extra painful part: HALF of your Social Security benefits count in this total annual figure.
Yes, you must count in this number as well when figuring out your taxes! “Provisional Income” encompasses various sorts of income the IRS uses to determine if they’re going to tax your Social Security.
As you can see, most people pay taxes on their Social Security (up to 85% of it) because their combined income from Social Security, 401(k)s, and other sources push them above what’s considered now to be very low thresholds for taxes to kick in.
Some estimates state that the original 10% of Americans being affected jumped to 25% in 1997, 32% in 2000, 39% in 2003, and 49% in 2014. The numbers now are even higher.
So, your provisional income consists of these things
- Distributions from any tax-deferred buckets (IRAs, 401(k)s, etc).
- Tax-exempt (or any other income) interest
- Employment Income
- 50% of your Social Security income
- Rental Income
An Example
Let’s use this example: let’s say you’re an individual single taxpayer, age 66 getting $16,000 from your Social Security. But you also have income from other sources to the amount of $50,000. Your Modified Adjusted Gross Income is half your Social Security plus wages after figuring in standard or itemized deduction. That is $8,000 + $50,000 – ($12,950 + $1750 being over age 65 deductions) = $43,300.
This means that you would now have to pay taxes up to 85 percent of your $16,000 in Social Security benefits (and of course on your other income you earned for the year).
How to Protect Yourself from Social Security Taxation
So, what’s a person to do? Are you just destined to spend your Golden Years locked into never ending Social Security tax? If you don’t plan, that can certainly be your fate.
The only solution, of course, is to stay below the current taxable thresholds. Meaning, you must remain below the $25,000 if single and $32,000 if married filing jointly after all your deductions are calculated in.
But as stated above, this is increasingly harder and harder to do.
Here are some ideas that can help you
1.) Contribute to a Roth IRA
Roth IRAs are specially designed individual retirement accounts that use after tax money (money you get in your paycheck after taxes have been taken out). The growth of this money, however, is forever non-taxable! This means that you do not have to report this as taxable income in your tax return!
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- This means if you contribute $500 a month for 30 years averaging about 10% a year in a stock brokerage account you could potentially grow this account to over a million dollars, all of which will be tax-free when you start pulling the money out!
- This income in retirement doesn’t count towards your Modified Adjusted Gross Income (MAGI). If you’re married filing jointly and your income is $30,000 but your Roth IRA is giving you another $40,000 income per year, this part doesn’t count! Your Social Security will not be taxed!
- You’re making $70,000 per year but you’re reporting $30,000 = no tax on your Social Security!
- There are special considerations when starting, contributing, and withdrawing from a Roth IRA so be aware of these before starting.
2.) Fund a Roth 401(k) or 403(b)
Some employers will allow you to contribute to the employer sponsored plan and offer Roth components within them. This is a great feature!
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- Growth on this money acts just like a Roth IRA – it’s all tax-free when you withdraw money from them (because they’re taxed up front so you don’t get the tax break starting out like a regular 401(k).
- You’re able to contribute much more to this vehicle than a regular Roth IRA.
3.) Closely manage your other retirement income sources
Remember, pension income, dividend income, and any other sources of income such as a part-time job will can add up to make your Social Security taxable. So closely adjusting these in retirement can certainly be beneficial.
4.) Consider taking withdrawals from your 401(k) that are taxable before you sign up for Social Security
With some financial planners, this is their specialty: maximizing the length of time you should draw down these other retirement accounts before Social Security. And by waiting (can be up to the age 70) you will lock in a larger Social Security benefit!. They then adjust everything for the least taxable hit. This is certainly an area to get professional advice, but the costs may be worthwhile.
5.) Minimize withdrawals from your retirement plans
You don’t have to start taking withdrawals from your 401(k) and 403(b) and IRAs until you’re the age of 72. If you plan just right, you will be able to take out just enough so that it keeps you in the tax-free zone. There is a minimum distribution at that time so be aware of this when it comes due!
6.) Consider Roth Conversions
This is where you convert your regular IRA accounts into the Roth equivalent before you start Social Security withdrawals. You will have to pay taxes on this when you convert (and it would be wise to talk to a tax or financial adviser before doing so) but there are ways to convert this in a strategic method, get the taxes over with, and then enjoy the rest of your life not being taxed on your Social Security.
Tip:
There is a great book that I’ve read by an author named David McKnight. It’s called The Power of Zero. In this book, the author gives actionable advice on not only keeping your Social Security from being taxed but also reducing your Adjusted Gross Income in various ways to get yourself in a complete zero percent tax bracket at retirement (meaning, keeping all your taxable income below a certain threshold to remain in the zero percent tax bracket).
For instance, the standard deduction for married couples filing jointly in 2022 is $25,900. This means you could earn up to this amount (then subtracting this deduction) and pay zero tax on that income. This book helps you to keep your reported income below these thresholds.
Summary
Taking a realistic look at Social Security today will help you prepare for tomorrow. Although it was originally intended as a tax on the wealthy, Social Security now taxes more and more Americans than ever before.
This means less money in your pocket in retirement.
Hopefully, this article has made you aware that your “guaranteed” income from Social Security in retirement may be a little less than you originally thought so you’ll be prepared for it.
However, there are ways to help protect this income later in your life, but you must start planning now.
As with anything financial, preparation is key.
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